Key macro variables look mostly great

Monetary policy is in easing mode, thanks to a significant reduction in inflation pressures. Corporate profits are very strong, and the stock market is making new highs. President Trump's second term promises much-needed and game-changing reductions in tax and regulatory burdens. All good. But threatened tariffs and a significant downsizing of the federal government will create headwinds in the near term; the benefits may take awhile to show up, but they will nonetheless be significant. 

Chart #1

Chart #1 updates the M2 money supply through October. The explosive growth of M2 relative to its long-term trend was the proximate cause of the Great Inflation of 2021-22. The federal government effectively printed $6 trillion and sent it to the public, where it sat in the form of currency and bank savings and deposit accounts for almost a year—without creating inflation, since the public had neither the willingness nor the ability to spend it. When life began to return to normal in early 2021, the public began spending the money. Soaring consumer demand—fueled by trillions of unwanted money—collided with supply chain disruptions and shuttered facilities to produce a roughly 20-25% increase in the price level. 

The Fed was late to react to the inflationary potential of all this extra money, but eventually they did, by raising interest rates beginning in the first half of 2021. As interest rates soared, M2 growth started slowing in 2022 and even declining. Today it is only modestly above its long-term trend. Inflation risks, accordingly, have plunged. 

Chart #2

Chart #2 shows my favorite measure of money demand: M2 divided by the level of nominal GDP. It's akin to the percentage of cash and cash equivalents that the average person or firm wishes to hold relative to their annual income. Very few people look at money demand, but I believe it is crucial to understand the interaction between money supply and money demand. As Milton Friedman taught us, inflation happens when the supply of money exceeds the demand for it. That was precisely what happened beginning in 2021; it was a classic case of too much money chasing too few goods.

Initially, money demand soared as $6 trillion in checks hit people's accounts; the public was willing to hold this money, and that explains why inflation didn't take off until much later. But money demand began to decline in 2021 as economic conditions began to normalize. Today, money demand is almost back to pre-Covid levels, and M2 is growing at a relatively slow pace. There is no longer an imbalance between the supply of and demand for money, and to prove that, we have only to know that inflation has slowed down significantly, even though many prices remain higher than most consumers would like.

Chart #3

Chart #3 shows the three components of the Personal Consumption Deflator, and they tell an important story about inflation. As the chart shows, non-durable goods prices have been unchanged since mid-2022, and durable goods prices have fallen since mid-2022. Only service sector prices have risen in the past 28 months, and most of that rise is due to housing and shelter costs, which have likely been overstated by faulty calculation methods (as I've explained in many previous posts). 

A true inflation is when all (or mostly all) prices rise. Inflation today is concentrated in the housing market, which has become relatively illiquid due to high mortgage rates and high prices. Illiquid markets are notorious for not reflecting true valuations. By almost every measure, housing prices today—coupled with sky-high mortgage interest rates—are overvalued and terribly unaffordable. 

Chart #4

Chart #4 shows the level of the real Federal funds rate (blue) and the slope of the Treasury yield curve (red). These are excellent indicators of how easy or loose monetary policy is. Money is tight when real yields are high and the yield curve slope is negative (inverted); those conditions have preceded nearly every recession in the past 65 years. Today monetary conditions are becoming less tight and the Fed is very likely to continue lowering the funds rate, with another cut expected at the December 18th FOMC meeting. 

Chart #5

Chart #5 shows the yield spread between high-yield and investment-grade corporate bonds (otherwise know as the "junk spread"). Credit spreads have rarely been as low as they are today, and this amounts to very positive economic fundamentals: a healthy economic outlook supports healthy corporate profits.

The contrarian in me suggests a different take: if things can't get much better than this, then maybe the market is overly optimistic and we're due for a fall?

Chart #6

As Chart #6 shows, after-tax corporate profits have been soaring relative to nominal GDP for the past 20 years, and they are now at record-high levels. Corporate profits today are running at a $3.1 trillion annual rate; it's no wonder the stock market has been so strong. 

Corporate profits are running at a spectacular rate, but so is the federal budget deficit, which has reached $2 trillion in the past 12 months. Corporate profits are adding $3 trillion every year to the pool of investable capital, but the federal government is borrowing about two-thirds of those profits to finance a variety of income redistribution schemes. This is not a prescription for a strong and growing economy. Imagine what might happen if the private sector of the U.S. economy were able to tap into that $2 trillion for more productive purposes! That is why Trump's DOGE is a terrific idea, but it will likely take some time before budget cuts translate into a positive force for the economy. 

Chart #7

Chart #7 compares the level of the S&P 500 index to the level of the European Stoxx 600 index. In the past 20 years, the rise in the S&P 500 index has been 2.5 times that of the Stoxx index. On a total return basis, over the past 20 years the S&P 500 has delivered a 650% return vs. a 315% return for the Stoxx index. Meanwhile, the dollar has gained 25% against the euro over the same period. 

Is it any wonder that the U.S. has been able to finance absurdly high federal budget deficits? The U.S. economy has become a magnet for the world's capital. 

Given our huge advantage in so many areas, do Trump's threatened tariffs really pose a significant threat to the health of the U.S. economy? More likely, as we have recently seen with Mexico, the mere threat of tariffs is enough to convince Mexico to halt immigrant caravans bound for the U.S. border.

 

Tariffs can't cause inflation. Only monetary imbalances do. Without a relaxation of monetary policy, Trump's promised tariff hikes won't be inflationary. But tariffs will act as a headwind to growth, since they are effectively a tax on consumption. 

Charts that call my attention

There's no unifying theme to this post. It's just a collection of charts which I find interesting, some reflecting positive developments, others suggesting caution.

Chart #1

Chart #2

Chart #1 compares the year over year change in the CPI with the ex-shelter version of same, which makes up about ⅓ of the total CPI. Of note, the ex-shelter change in the CPI has been 2% or less in 13 of the past 16 months. If you believe, as I do, that the BLS's method for calculating housing/shelter inflation is flawed, then that means the Fed managed to tame inflation well over one year ago. As I've shown in previous posts, it looks like shelter costs, which drive ⅓ of the CPI, are based on the year-over-year change in US housing prices from 18 months ago; that is the only reason the overall CPI has not fallen below 2%. Chart #2 illustrates this. In the past year or so, housing prices have increased at a much slower rate.

Chart #3

Chart #3 compares industrial production levels in the U.S. and Eurozone. There are several remarkable things going on here. For one, U.S. industrial production levels haven't increased at all over the past decade! Two, Eurozone industrial production is tumbling in a way that suggests recessionary conditions. One reason for this is Germany's obsession with renewable energy sources at the expense of cheap and reliable natural gas and petroleum. Germany's electrical grid is seriously compromised as a result, and electricity costs have skyrocketed. Read all about it, courtesy of Robert Bryce, the best energy analyst I know. 

Key takeaway: the goal of renewable energy is a pipe dream, and seeking it out is kneecapping electric grids and retarding economic progress everywhere, penalizing the poor to satisfy the preening elites who will apparently make any sacrifice in the name of quixotically saving the planet. Cracks in the green energy coalition are already forming in Holland, and this seems sure to spread to other countries in coming years.

Chart #4

Chart #4 makes it clear that housing construction is depressed. Housing starts have been falling for the past two years, and builders see little hope in sight for improvement.

Chart #5

Chart #5 shows why housing is depressed. Mortgage rates have soared in recent years, and new mortgage initiations have plunged and stagnated. Very few can afford to buy homes given sky-high prices coupled with nearly 7% interest rates on mortgages. At the same time, very few homeowners want to sell, since it would mean giving up their 3% mortgages. This is an unstable situation that will eventually be resolved by falling home prices and/or falling mortgage rates.

Chart #6

Chart #6 compares the strength of the dollar (blue line, inverted), with an index of non-energy industrial commodity prices in constant (real) dollars. Up until a few years ago, commodity prices were strongly and inversely correlated with the strength of the dollar (i.e., a stronger dollar tended to depress commodity prices while a weaker dollar tended to boost commodity prices). This relationship broke down starting in early 2021 when inflation began to rise. I suspect that restrictive monetary policy will eventually restore this correlation—meaning commodity prices face downward pressure.

Chart #7

Chart #7 is constructed in a similar fashion to Chart #6, but instead of commodity prices it shows real gold prices. Commodity prices fell sharply beginning in early 2022, but gold prices started to soar in late 2023 in the wake of the Hamas attack on Israel. Unlike virtually all other commodity prices, gold prices have been making new all-time highs (on both a nominal and inflation-adjusted basis) ever since. I think the conclusion is obvious: geopolitical tensions in eastern Europe and the Middle East are close to red-hot. Gold is acting like the ultimate port in a storm that threatens another world war. Steven Hayward describes the mess we're in succinctly. Another thing this chart shows is that the dollar is relatively strong and strengthening of late; both the dollar and gold are benefiting from their status as safe-haven assets. 

Chart #8

I've been fascinated by the decade-long decline in small cap stock prices relative to large cap stock prices. On a total return basis, the S&P 500 index has more than doubled the return on the Russell 2000 index over the past decade! Chart #8 helps illustrate this, while also suggesting that the Fed's monetary policy tightening and easing cycles has had something to do with this. 

The blue line in this chart is the ratio of the Russell 2000 Small Cap Index to the S&P 500 Index. The red line is the inflation-adjusted (real) level of the Fed funds rate, which in turn is the best measure of how tight or how easy the Fed's monetary stance is (inverted to show that a rising red line corresponds to easier monetary policy and vice versa). It's not a perfect correlation, but it seems that Fed easing (which usually comes in the wake of economic weakness) inevitably leads to small cap stock outperformance. By now it's clear the Fed has embarked on an easing cycle. With Trump's policies promising a significant reduction in regulatory burdens (which would help smaller companies much more than larger companies), I think we may therefore be at the beginning of a period of small cap outperformance.

Chart #9

Chart #9 shows the astonishing outperformance of US equities vs. Chinese equities over the past 30 years. (Both y-axes have a similar ratio scale, and both are plotted on a logarithmic basis). China's economic model has failed utterly to compete with ours.

Milei and Trump share victories

I've written several times about my admiration for Argentina's Javier Milei (see MAGA down south). Many called him crazy, but he, like Trump, overcame seemingly insurmountable odds to beat the candidate of the ruling party. Argentina was teetering on the precipice of an economic collapse, and now, after just one year of Milei's ministrations, inflation has been radically downsized, from 25.5% per month when he assumed office a year ago to only 2.7% last month, and the economy is once again growing, with some projecting real GDP growth of almost 10% in the coming year. Confirming the dramatic improvement in the outlook, the free market peso (the "Blue" dollar) has been almost unchanged over the past year (see Chart #1), and the Argentine stock market (using ARGT as a proxy) has surged by almost 75% in the past year in dollar terms.

Chart #1

U.S. consumers are still reeling from the jolt of inflation unleashed by $6 trillion of Covid "stimulus" spending, but as I've been pointing out for almost two years, there is clear evidence that inflation has since returned to 2% or so. Many problems remain, however, and a clear majority of the public felt that Trump was more likely to deal successfully with those problems than Harris. 

My Argentine friend, Nuni Cademartori, is both a talented artist and a fan of Trump and Argentine President Milei, whom many consider to be Argentina's Trump. Milei is also a fan of Trump's, and was reportedly the first foreign leader to congratulate Trump on his victory in person. I publish Nuni's congratulatory cartoon below, and I join Nuni in breathing a sigh of relief that our futures look brighter. Three cheers for Milei and Trump!

P.S. (Nov. 21). The obvious convergence of the peso’s market and official rate (now only 10% apart) is good evidence that Milei’s program is working. It means that the official rate is essentially the same as the market rate, which in turn means that the government could effectively dollarize the economy at today’s rate (approximately 1000-1100 pesos per dollar) and at the same time liberalize the exchange market so that capital could flow in and out freely. The rate might vary somewhat, but it is not far off from where it should be right now. The dynamic that most observers miss is that as confidence in Milei and Argentina grows, more capital wants to come into the economy than wants to leave. That means the demand for pesos is strong relative to the supply of pesos (which is growing at a slower and slower rate) is greater than the supply of pesos, and that is why inflation is falling. 

It’s no wonder that the Argentine stock market is on fire. It’s beaten the S&P 500 for the past 1, 2, 3, 4, and 5 years, and by a wide margin. 

Abundant reserves enabled a soft landing

In the Old Days (pre-2009), when bank reserves paid no interest—they were considered a "dead" asset—banks held the minimum amount of reserves necessary to collateralize their deposits. When the Fed needed to bring inflation down (usually as the result of a prior mistake that allowed inflation to rise), the Fed restricted the supply of reserves in order to force their price (the cost of borrowing reserves) higher, and to slow the growth of the money supply and bank lending. Higher interest rates and a scarcity of money eventually did the job, but unfortunately, a recession typically followed, heralded by sharply rising credit spreads. 

Around the end of 2008, the height of the financial panic at the time, the Fed made a momentous decision: reserves would become an interest-bearing and default-free asset, and there would be plenty of them. The Fed would control short-term interest rates directly, without having to restrict the supply of reserves. The Fed would pay interest on reserves using funds it received on its holdings of Treasury and mortgage-backed securities, which in turn were purchased by issuing reserves. Reserves effectively became T-bill substitutes, and as such, an ideal asset for the banking system.

At first, most analysts, myself included, feared that an abundance of reserves would result in a surge of lending and higher inflation. Fortunately, that didn't happen. In fact, for the next 11 years, inflation and interest rates would be low and relatively stable. In the first half of 2009 I stopped worrying about abundant reserves becoming inflationary, because I realized that banks had an almost insatiable appetite for holding reserves. The supply of reserves had exploded, but so had the demand to hold them. Thus, abundant reserves were not inflationary.

Then came Covid-19, and panicked politicians shut down the economy. To compensate for the loss of income which followed, Treasury sent roughly $6 trillion in checks to individuals and companies over the course of the next 18-20 months. Initially, most of the extra money sat idle in bank savings and deposit accounts. Then, in early 2021, as the economy began to get back on its feet, people began to spend the money, only to find that supply chains had been disrupted. Demand for goods and services soon outstripped supply, and inflation took off. If Milton Friedman had been alive at the time, he would have realized that his helicopter-drop-of-money analogy had become real: dumping trillions of extra dollars on the economy had ballooned the price level by 20-25%. In early 2021 I began forecasting a serious increase in inflation because I realized that the demand for all the extra money that had been created was beginning to decline.

To its everlasting regret, it took the Fed a year or so to figure out that rising prices were not in fact "transitory," but the real thing. So in March '22 they began the process of tightening by raising short-term interest rates. It wasn't easy to break the back of inflation, because the supply of money (M2) had surged by $6 trillion; they not only needed to reduce the money supply but to persuade (via higher interest rates) people to not spend the money so fast. Meanwhile, pundits and economists of every stripe predicted that, as it always had over the previous 50 years, a recession would inevitably follow the Fed's energetic monetary tightening. Very few, myself included, thought that a monetary tightening that occurred during a period of abundant reserves and ample liquidity would not result in a "hard landing."

To the great surprise of nearly everyone, we have experienced a "soft landing." The Fed has regained control of monetary conditions, inflation has come down to its target, and the economy has managed to grow at a decent rate throughout the tightening process. Abundant reserves arguably were the key. Thanks to abundant reserves, liquidity has been abundant in the financial markets as evidenced by low and relatively stable credit spreads. Financial markets were thus able to act as a shock absorber for the disruption to the economy caused by higher prices and higher interest rates.

Unfortunately, as Milton Friedman famously said, there is no free lunch. Supercharged federal spending has distorted the economy by not only causing inflation, but also by transferring trillions of dollars from the productive sector of the economy to consumers and enlarging the size of the government in the process. Pre-Covid, the federal deficit was almost $1 trillion per year. Currently, the deficit is running at almost a $2 trillion annual rate. Government payrolls have surged at a more than 2% annual rate since early 2023, even as private payroll growth has slowed from 4% in late 2022 to now only slightly more than 1%. Government spending has been the main source of economic growth in recent years, while business investment and manufacturing have been weak. This is not a prescription for solid growth in the years to come. Although real GDP growth in recent years has been about 2.2-2.4% annually, it is likely to slow down in the years to come unless policy shifts in favor of investment rather than transfer payments.

Chart #1

Chart #1 illustrates the gigantic increase in bank reserves that began in late 2008 when the Fed decided to make reserves abundant while also paying interest on reserves. Prior to that, reserves were a direct constraint on bank lending, since banks needed to hold reserves to collateralize their deposits, and reserves paid no interest. QE4 (aka massive Covid-related "stimulus") was the proximate cause of our destructive bout of inflation in recent years. Prior episodes of Quantitative Easing were not inflationary because they were neutralized by strong demand for cash and cash equivalents.

Chart #2

Chart #2 shows the difference between credit spreads on investment grade and high-yield corporate debt. This is an excellent measure of future economic health and financial market liquidity (higher spreads reflect concern about corporate profits and a general shortage of liquidity, while lower spreads reflect optimism about future economic growth and liquidity). Big spikes in credit spreads have reliably predicted recessions. Today, credit spreads are very low, and recession risk is also low—but that doesn't rule out sluggish growth.

Chart #3

Chart #3 shows the level of real economic growth (blue line) and different trend growth rates. The 3.1% annual trend line was in place from the mid-1950s through late 2007, while the 2.3% trend line began in mid-2009. If the economy had followed that 3.1% growth rate following the 2008-9 recession, it would be about 20% larger today.

Chart #4

Chart #4 shows the year over year change in the GDP deflator, the broadest measure of inflation. From a peak of almost 8% it is now only slightly above 2%. This confirms that the Fed has succeeded in controlling inflation. Unfortunately, the price level today is still almost 20% higher than it would have been if inflation had been instead averaged less than 2% per year, as it did in the decade leading up to Covid.

Chart #5

Chart #5 shows the 6-mo. annualized change in the Personal Consumption deflator and its core (ex-food and energy) version. By these measures inflation is also once again under control.

Chart #6

Chart #6 shows the three components of the Personal Consumption deflator. Service prices, dominated by shelter costs, are the only ones rising. Non durable goods prices are almost unchanged for the past two years, while durable goods prices have been declining for two years. Deflation in the durable goods sector has returned.

Chart #7

Chart #7 is a reminder that every recession prior to the Covid recession was the result of tight monetary policy. Monetary policy was tight because real interest rates were very high and the Treasury yield curve was inverted. Those two conditions have returned of late, but there is no recession in sight. What's different this time? Abundant reserves.

Chart #8

Chart #8 shows the ISM purchasing managers survey of the manufacturing sector. This has been notably weak since late 2022. That the economy has grown by almost 3% in the past year is due almost entirely to government spending and transfer payments. 

Chart #9

Chart #9 shows the monthly change in private sector payrolls over the past 3 years, as well as the rolling 6-mo average of same. In early 2022, payrolls were growing by about 600,000 per month; now they are growing by only 100,000 per month. (I assume the very low number for October to be the result of hurricanes, strikes, and random variations which can and do happen quite often.) While this is not necessarily a precursor of recession, slow jobs growth does point to a loss of vitality in the economy which could persist and/or worsen. We are not likely to see 3% GDP quarters on a sustained basis; be prepared for 2% or less. At least that will make it easier for the Fed to continue to cut interest rates.

Slow M2 means low CPI

Long-time readers of this blog know that I have been one of only a handful of observers who have linked rapid M2 growth (i.e., money printing) to the big inflation problem that hit the US economy beginning in the first part of 2021. The source of the M2 growth was the government's decision to send out some $6 trillion of checks to the public to compensate for Covid shutdowns and their damaging effects on the economy. At first, most of this money sat idle in consumers' checking and savings accounts as a hedge against great uncertainty and also because consumers had little ability and little willingness to spend it. This amounted to an enormous increase in the demand for money which effectively neutralized the enormous increase in the supply of money. But as life began to return to normal in early 2021, the demand for money declined, and the money was released (monetized) into the economy. Unwanted money fueled a dramatic increase in the price level (otherwise known as inflation). 

Fortunately, this problem began fading away more than two years ago, and it continues to do so. Money supply and money demand have returned to more normal levels, and inflation (abstracting from the government's flawed measure of shelter costs) has been 2% or less the for the past year or so. 

Regardless, it is still vitally important to monitor money supply and demand. So far, nothing out of the ordinary seems to be happening, and that implies no unpleasant inflation surprises for the foreseeable future. The following charts include M2 as of the end of September, and my estimate for Q3/24 GDP. 

Chart #1

Chart #1 shows how the surge in the federal deficit was mirrored by an increase in M2 growth. The link between the two dissolved in the latter half of 2022, with the result that ongoing deficits, though still quite large, are no longer being monetized.

Chart #2

Chart #2 tracks the level of the M2 money supply (currency, retail savings and checking accounts, CDs, and retail money market funds). From 1995 through late 2019 M2 grew at a fairly steady rate of 6% per year, and inflation was relatively low and stable. M2 then surged beginning in April '20 and peaked in early '22. M2 now is only about $1.6 trillion above its 6% trend growth line, and is growing at a modest 3-4% annual rate. 

Chart #3

As Milton Friedman taught us, inflation happens when the supply of money exceeds the demand for it. The Fed publishes the M2 measure of money supply once a month. But nowhere will you find a measure of money demand, except here. My measure of money demand is driven by dividing M2 by nominal GDP, which is shown in Chart #3. The best way to understand this is to think of it as the amount of cash and cash equivalents the average person wants to hold relative to his or her annual income. As the chart shows, money demand tends to rise during recessions, and to decline during periods of growth and stability—with the exception of the 2009-2019 period, when it steadily rose. 

Money demand soared in the wake of Covid shutdowns, then began to fall as Covid fears faded and the economy revived. It is now only modestly higher than in the pre-Covid period. Money supply and money demand, I would argue, are now back in balance, and that explains why inflation has declined and is likely to remain low.

Chart #4

Chart #4 shows M2 growth (blue line) and the year over year change in the CPI (red line, shifted one year to the left). From this perspective, inflation picked up about one year after M2 surged, and it began to decline a year or so after M2 growth peaked. The red asterisk marks the change in CPI ex-shelter costs, which is, I think, the appropriate measure to watch. The chart further suggests that inflation has fallen pretty much as you would expect, given the decline in M2 growth, and it is likely to remain muted for the foreseeable future. 

The enormous net worth of the US private sector

This post extends a series of similar posts I've made over the past 15 years. It highlights the net worth of the U.S. private sector: the net value of assets and liabilities of individuals and non-profit organizations.  As of June '24, the total net worth of the U.S. private sector was $164 trillion, and the net worth of the average person living in the U.S. was almost half a million dollars. 

Does the proliferation of billionaires distort the picture? Not much. According to Forbes, at last count the U.S. had 2,800 billionaires, whose net worth totaled in the range of $17-20 trillion. The net worth of the Forbes Top 400 billionaires totaled $5.4 trillion. If we exclude all billionaires from the total, the net worth of the average American would be about $425K, which is still pretty impressive.

Chart #1

As Chart #1 shows, private sector net worth has increased by 167% over the past 20 years, and now stands at $164 trillion. The biggest gains have come from financial assets (stocks, bonds, and savings accounts), which have increased 149%. Real estate assets have increased 144%, while liabilities have increased a mere 44%. The federal government is heavily indebted, but not so the private sector! 

Chart #2

Chart #2 shows the real, inflation-adjusted value of private sector net worth. Net worth peaked at 166.7 trillion in December '21, and has since declined to $164 trillion. The rather spectacular gains of the stock market and housing in recent years have been diluted by inflation. Still, real net worth is still on a rising path, averaging gains of about 3.6% per year.

Chart #3

Chart #3 divides real net worth in Chart #2 by the U.S. population (about 342 million). Real per capital net worth peaked at $509,500 in 12/21, and fell to $481,000 through June of this year, due to the effects of inflation and an increasing population. Still, it has risen on average by about 2.4% per year. If this continues, by 2054 the average American will be worth $1 million in today's dollars. 

Federal spending is the problem, not taxes

Given the upcoming elections and all the "disinformation" floating around,  it's worthwhile clarifying some of the facts behind fiscal policy. 

As the following charts show, our biggest problem is too much spending, much more so than any shortfall of tax revenues. 

Chart #1

Every taxpayer should frame Chart #1 and put it somewhere prominent. This shows the staggering increase in both federal spending and federal tax revenues in recent decades. 

Chart #2

Chart #2 shows the major components of federal revenues, all of which—with the exception of the estate and gift tax—have surged in recent decades. Individual income tax receipts have almost quintupled since 1990! And by the way, eliminating the "death tax" would amount to a rounding error in the federal budget, since it collects only 0.6% of total federal revenues. Think of how much more efficient our economy would be if millionaires and billionaires stopped spending big bucks on tax attorneys in order to escape this onerous tax. The negative impact of this tax on the economy is an order of magnitude larger than the revenues it manages to generate. 

Chart #3

Chart #3 shows federal spending and revenues as a percent of GDP. Note that spending has averaged a bit less than 20% of GDP since WWII, while today it is about 23% of GDP. Bringing it down is going to be difficult, since interest payments on federal debt now add up to more than $1 trillion per year (3.8% of GDP currently) and are rising (see Chart #4). Meanwhile, revenues have averaged about 17.5% of GDP over the same period, and are currently a bit less than 17%. 

Note also that revenues have been a fairly constant share of GDP over the past 50 years, while income tax rates have been all over the map. Trump's 2018 tax cuts occurred at a time when revenues were about 16% of GDP, and since then they have surged both in real and nominal terms. Cutting tax rates does not necessarily add up to lost revenues. On the contrary, setting tax rates at lower and more reasonable levels can end up boosting tax revenues by stimulating investment and boosting the economy's productivity.

Chart #4

Today's edition of Steve Moore's Hotline (see bullet point #2) makes an important point which should be added to this discussion. "... even if you taxed every penny of income earned by millionaires, it wouldn't be enough to close the deficit." That refers to the current deficit, not the total debt owed to the public, which is closing in on $30 trillion. 

Steven Hayward, one of the contributors to the excellent Powerline blog, notes that it is NOT true that "the rich enjoy lower tax rates than the middle class." In fact, "The rich already pay higher federal tax rates. Those with higher income pay a larger share of the tax burden than their share of national incomes.”

UPDATE (10/23/24): Chart #5 below provides proof for my assertion above ("Cutting tax rates does not necessarily add up to lost revenues.)

Chart #5

A close look at Inflation and interest rates

Headline inflation numbers are a bit higher than the Fed's target, but that's entirely due to the way shelter costs are estimated. On balance, it's clear that the Fed has brought inflation back down to acceptable levels. 

Relative to ex-shelter inflation, interest rates remain quite high, especially mortgage rates. The Fed has plenty of latitude to lower short-term interest rates, and I expect another cut in November.

Chart #1

Chart #1 looks at the headline measure of the CPI as well as the ex-energy version, both measured over a rolling 6-mo. annualized basis. Note how much less volatile inflation is when you subtract energy prices. These two measures currently are straddling the Fed's 2% target. Notably, the total (headline) CPI is up at only a 1.6% annualized rate in the past six months.

Chart #2

Chart #2 compares the total CPI to the CPI less shelter version, both on a 6-mo. annualized basis. Here we see that both measures currently are below the Fed's 2% target. Notably, the ex-shelter version is only up at a 0.1% annualized rate! If it weren't for the BLS's faulty measurement of shelter costs, which greatly overstates housing inflation, inflation would be essentially ZERO. 

As I've noted many times in the past year or so, shelter cost inflation has been high and declining slowly (more slowly than I expected). It should continue to decline over the next several months, and that will cause the current gap between total inflation and ex-shelter inflation to narrow.

Chart #3

Chart #3 compares the same two measures as Chart #2, but on a year over year basis. The ex-shelter version of the CPI has been less than 2% in 14 out of the past 17 months, and it currently stands at a mere 1.1%. 

Chart #4

Chart #4 compares the 5-yr Treasury yield to the year over year change in ex-energy inflation. I like to use this version of inflation, because as noted in #1 above, energy is far more volatile than any other component of the CPI. Here we see that interest rates tend to move with inflation, but with a noticeable lag. And with ex-shelter inflation now at 1.1% (note the blue asterisk at the bottom right-hand corner of the chart), there is plenty of room for Treasury yields to decline.

Chart #5

Chart #5 shows the level of real and nominal 5-yr Treasury yields, plus the difference between the two, which is the market's implied inflation forecast for the next 5 years. Inflation expectations currently are about 2.2%, which should please the Fed. Here again we see that there is plenty of room for interest rates to move lower.

As an aside, I note that swap and credit spreads are trading at relatively low levels, which is a sign of abundant liquidity conditions and a healthy outlook for corporate profits. Economic conditions in general are healthy, but I continue to worry about the housing and property markets, which are burdened by very high interest rates and high prices. 

Chart #6

Chart #7 shows the level of 30-yr fixed mortgage rates and the 10-yr Treasury yield, plus the spread between the two. Mortgage spreads currently are quite wide (about 225 bps), compared to where they trade in normal conditions (about 150 bps). This wider-than-normal spread is largely driven by investor's reluctance to buy mortgages when the risk of refinancings is high. People realize that interest rates are high relative to inflation, and they understand also that lower interest rates would spark a wave of refinancings of mortgages that have closed in the past two years. In other words, the perceived downside risk of mortgage bonds is uncomfortably high, and that is depressing the prices of mortgage bonds. If anything this means that while lower mortgage rates are likely in the offing, rates are likely to come down slowly. That will keep downward pressure on housing prices in the interim.  

This wasn't a monster employment number

This morning the market was apparently surprised by a stronger-than-expected jobs number. Private payrolls rose by 223K in September, vs. an expected gain of 125K. Some called it a "monster" number. From my perspective, however, nothing changed at all. Private sector jobs are growing by about 1.3 to 1.4% per year, as they have been for the past several months. This is moderate growth, probably enough to deliver overall economic growth of 2% per year or so. A nothing-burger.

Chart #1

Chart #1 shows the year over year change in private sector jobs, the only ones that really count. The big story, really, is the huge deceleration in growth over the past few years, followed by relatively moderate and steady growth in recent months. Even if we looked at jobs growth over a 6-month period, the story would be the same. Jobs numbers are very volatile on a monthly basis, so you have to look at growth over a multiple-month basis. And when you do that you see that nothing much has changed of late. 

There is nothing in today's report that should influence the Fed to change course. Inflation is yesterday's problem, and jobs growth is moderate. Lower interest rates are appropriate.

Looking pretty good: M2, GDP and corporate profits

I'm certainly not an apologist for the Biden administration, but as the charts below show, the economy on balance has done pretty well in the past several years. The monetary source of the Big Inflation of 2021-2022 has been largely extinguished, real economic growth has exceeded expectations, and corporate profits have been fairly spectacular. 

Chart #1

Recent revisions to the GDP statistics showed the economy posting better than 2.3% annual growth over the past several years (see Chart #1). Of course, this is still far less than it might have been had the economy tracked the 3.1% annual growth path that began in 1966 and continued through 2007. But, considering that many observers were predicting a recession in 2023, economic growth has been surprisingly strong. My own forecast of growth in recent years called for growth slightly in excess of 2% per year, and I am pleasantly surprised to have been too cautious, albeit much more optimistic than most. 

Chart #2

Chart #2 shows the level of the M2 money supply. The huge bulge in M2 tracks the massive government stimulus payments in 2020 and 2021 that were essentially financed by money printing. With a delay of about a year, some $6 trillion of monetary "stimulus" subsequently turned into raging inflation in 2021 and 2022. The Fed was unfortunately slow to react, but by late 2022 they had raised rates by enough to neutralize excess M2 and thus slow inflation. 

Chart #3

Chart #3 is key to understanding the interaction between excess money and inflation. A $6 trillion surge in deficit-financed government spending was not initially inflationary, because the demand for money (which is proxied by the ratio of M2 to nominal GDP in in the chart) surged. That was the logical result of handing tons of cash to a public that had little desire and even less ability to spend it during the lock-down phase of the Covid disaster. But life began to return to normal in early 2021, and the public started to spend the money (i.e., money demand fell). The problem, of course, is that extra spending collided with supply-chain shortages and rising prices were the result. Money demand has almost returned to its pre-Covid levels now, the economy has resumed a more normal growth path, and inflation has become a non-issue for at least the past year. 

Chart #4

Chart #4 compares the level of corporate profits (after-tax, and ex Fed profits) with nominal GDP. 

Chart #5

As Chart #5 shows, profits are at all-time record levels compared to the size of the economy, and they began their current surge (briefly interrupted by Covid) in 2019, following Trump's 2018 reduction in the tax rate on corporate profits from 28% to 21%. Since the end of 2018, corporate profits (after-tax and adjusted for continuing operations and ex-Fed profits) have risen 58%, while nominal GDP rose 39%. Despite the sizable cut in tax rates, corporate tax payments to Treasury rose from a low of $189 billion in the 12 months ending Jan. '19, to $516 billion in the 12 months ending August '24—a whopping increase of 173%! And, not surprisingly, the S&P 500 is up 130% since 2018. 

Art Laffer, take a bow!

While it's great to see evidence that what's good for corporations is also good for the economy, there's a cautionary message here. If, as they have repeatedly promised, a Harris-Walz administration allows the Trump tax cuts to reverse as scheduled at the end of next year, this could pose a significant threat to the economy and, by extension, the stock market. 

Please excuse the absence of posts this past month. I haven't had much to say, and I needed a break. Plus, we had a delightful trip to Greece.